Wednesday, January 5, 2011

RRSP vs. TFSA: Downside Protection Considerations

Much has been written about the relative merits of saving in RRSPs and TFSAs. The discussion usually comes down to a close call based on some elaborate calculations. For me the choice is clear.

For those who make a good living, marginal tax rates are somewhere near 45%. Given \$10,000 of income burning a hole in your pockets, the choice is to put the \$10,000 in an RRSP or to pay \$4500 in taxes and put \$5500 in a TFSA.

If all goes well in the future then it can be a close call which approach is better. But what if your financial future is terrible? What if your income is so low that you will be able to withdraw the \$10,000 from your RRSP during retirement and pay a low tax rate? In this case, \$10,000 from the RRSP is much better than \$5500 tax-free from your TFSA. Choosing the RRSP over a TFSA offers some downside protection.

Of course, it’s better to save enough to fill both your RRSP and TFSA, and if your marginal tax rate is much lower than 45% you may prefer saving in a TFSA. Overall, I fill my RRSP first because it will provide a better buffer against the possibility of a meagre retirement. If I’m rolling in cash during retirement then it doesn’t much matter whether I saved in an RRSP or TFSA.

1. I've been trying to figure out where to put the money I have to save this year (in an RRSP or TFSA) and found a calculator that made checking out some different scenarios pretty easy. You can make some different assumptions about your retirement income, and see if you should go with TFSA or RRSO now.

2. Very smart. I never looked at it that way before.

3. @Patrick: Thanks. I think this is yet another case where it's possible to do some exact calculations and come up with a not very useful answer.

4. Yes, that's exactly right. I've done those calculations myself!

5. Interesting, I came to the opposite conclusion for the "what if the future is terrible" scenario. I figure the TFSA was the one to fill first because if something happened before retirement, I could get the money out without a tax hit, and the contribution room would still be there to get going again.

Of course, I was in the bottom marginal tax bracket for 2009, and might not be much higher for 2010.

6. @Potato: My reasoning depends on being at the top (or near the top) marginal tax right presently. I agree that TFSAs look more attractive than RRSPs when you're presently in a low marginal tax rate.

7. @Potato: That's true, but you'd have less to take out.

However, ss Michael replied, being in a lower tax bracket at contribution time makes a big difference.

8. Of course, these sorts of comparisons make the assumption that the RRSP rules won't change and tax rates after retirement will remain substantially lower. While it's not something I worry about a lot, over a long enough time frame anything is possible.

Granted, the rules for TFSAs could change as well, but collecting taxes from an instrument with "tax-free" right there in the name (and holding capital on which income tax has already been paid) seems more difficult politically than raising tax rates on RRSP withdrawals.

Just a thought.

9. @Chris: Your comment definitely applies to the calculations some do to come up with some slim advantage for one or the other in normal circumstances. However, the conclusion that RRSPs work better for a disaster scenario later in life isn't very sensitive to changes in tax rules.

10. There's a general rule in taxation - a tax deferred, that is, one that will be triggered by the taxpayer - will almost always be paid at a lower rate. I'm not referring to the emergency situation, but in most other cases, where the taxpayer has some control over timing.

For this reason and those you've mentioned, very much agree that RRSP is favourable for those paying much income tax; I'd put the bar far lower than the 45% marginal tax bracket.

11. @Anonymous: Agreed. I haven't formed an opinion on how much lower than a 45% present marginal tax rate the preference for an RRSP over a TFSA persists.

12. I have to say being a savvy investor myself, that is a valid argument. However one would need to not only do the math but take into consideration OAS and GIS clawbacks and pension upon retirement.

IMO also if you take this sort of view that you can make less money in the future, it might lead to a person having less incentive to work harder and make more.

13. @Canadian Investor: We're talking about a person who is currently paying the top or near top marginal tax rate and who is trying to decide whether to save in an RRSP or TFSA. This eliminates GIS clawbacks in all but the most extreme scenarios. OAS clawbacks only occur if this person has a high income in retirement. So, I think my argument still holds.

I think it is possible to consider a range of possible futures including good and bad financial fortune without losing the incentive to work.

14. OAS clawbacks kick in at >68K income per year, for most people it won't be an issue. Couple of other advantages of RRSP for some in the high(er) tax brackets are: If one has to go a while without a job, then you can withdraw from the RRSP and pay a lower tax. Also, I believe there are 2000\$ to be claimed per year off of an RRSP/RRIF for pension as well as 5000\$ to be withdrawn tax free per year from RRSP/RRIF.